Should we fear equity market valuations?

By Sophie Chardon,
Cross-Asset Strategist

By many measures, stock markets can currently be deemed overvalued. Yet, taking a longer historical perspective, we find that “soft Goldilocks” environments such as prevails today (with low but stable growth, and positive but contained inflation) tend to favour higher valuations. As do the improved global macroeconomic outlook and the richness of other asset classes, credit and government bonds notably.

In and of themselves, we would thus not consider current valuations as a bearish signal for equities. We show that this backdrop can prevail as long as earnings dynamics are robust. And the ongoing earnings season does depict a rather strong picture globally.

With central banks in very cautious mode, we see further benign quarters for the ongoing market cycle. We thus consider valuation as a driver of regional preferences rather than a determinant of the appropriate exposure to equities.

With one of the largest stock market rallies underway in the US, concerns are inevitably arising as to the right timing for profit-taking. Since 2012, price-to-earnings (P/E) ratios have risen continuously on the back of expansionary monetary policies, especially in the US. Late 2016, equity multiples stretched again, bringing P/E ratios close to decade highs, albeit lower than the levels reached during the Internet bubble (Chart I). Is this enough to consider current valuations as a bearish signal? We do not think so.

Valuations are indeed high…

To avoid focussing solely on the P/E, we have built a valuation indicator based on a large set of metrics (see details in the Box hereafter) . Our composite indicator entered “high valuation” territory (i.e. above the 0.7 threshold, Chart II) in November 2016. More precisely, the most stretched valuation metric is the EV/EBITDA while the FCF yield appears a mitigating factor. Although it can be reassuring to see a high level of FCF yield, suggesting that corporates have the financial strength to face a short-term economic slowdown, this also reflects very low investment spending over the past few years, which eventually stands to dampen corporate earnings (hence analyst expectations of long-term earnings growth).

… but that should not be considered as a bearish signal

Looking back several decades (Table I), we cannot posit that high valuations are a sufficient condition to automatically and instantaneously trigger a bear market. Market downturns can occur at any level of valuation. That was obviously the case for bear markets initiated by external events, such as the Gulf war and oil shock in 1990 or the European sovereign crisis in 2011. But even the worst post-WWII bear market that started in 2007 did so from relatively moderate valuation levels. Admittedly, the internet Bubble burst as valuations were reaching all-time highs, but they had been flashing red signals for almost three years when the bear market began.

Interestingly, that bear market of 2000 actually began when earnings growth started to decelerate. A congruence that is indeed true of most of the bear markets witnessed over past decades. Which is why, barring an external shock, we think high equity valuations can persist as long as earnings dynamics are supportive. And for now, analyst expectations are holding up well: US corporations should deliver robust 2017 growth and 2018 looks set to follow the same pattern. With economic growth the most important driver of corporate earnings, our global macro outlook definitely supports a continuation of current trends.

In fact, valuations are consistent with the new economic paradigm...

We think that the onging shift in economic paradigm towards structurally lower growth, inflation and interest rates affects valuation metrics. Notably, the P/E ratio seems sensitive, amongst others, to the inflation regime. Using very long-term historical data provided by Professor Shiller, we find that an economic environment of positive but contained inflation – typically between 1 and 3% - supports higher valuations than extreme regimes such as deflation or hyper-inflation.

Another positive characteristic of the current “soft Goldilocks” environment is that the volatility of macroeconomic variables is lower than in the past. Indeed, for several quarters, GDP growth, unemployment and inflation volatilities have all been close to the lower-end of their historical ranges (Chart IV). Also, dispersion within the economist and analyst consensus is at all-time low. In a period of lesser economic uncertainty, when future cash flow prospects appear more stable, investors are likely to accept richer valuations to gain exposure to equity market returns.

… and alternatives are limited

Much has been said about the relationship between equity valuation and interest rates. Clearly, once (or if) equities are sold, the proceeds must be re-invested, usually in government bonds. As such, the relative value between the two markets matters. And the fact is that years of extraordinary stimulus measures by central banks, intent on reducing borrowing costs for businesses, governments and consumers, have inflated bond prices. It follows that, so long as government and corporate yields remain in their current regime, close to or below dividend yields – our baseline scenario – investors are unlikely to shift out of equity markets, even as the earnings yield declines.

No irrational exhuberance so far

If we are truly experiencing a shift in economic paradigm, comparing market valuation to a historical average (even long-term) might be misleading. We have thus combined the above-mentioned factors in a simple model aimed at explaining the behaviour of the P/E ratio over time. It shows that 10-year US rates (reflecting alternatives), GDP and inflation volatility (macroeconomic visibility) and the personal consumption expenditure deflator (inflation regime) explain the trend in P/E ratio (Chart VI). More specifically, it indicates that the recent upward trend is fully aligned with the improvement in macroeconomic visibility and the poor inflation data. By contrast, the valuation levels reached in 1998-2000 cannot be explained by this set of explainatory economic variables, hence the “bubble” terminology used to describe that period.

In conclusion, we find that current high valuations are not worrying as they are fully aligned with the “soft Goldilocks” economic environment. Yet, going forward, high valuations 1/ dampen equity market expected returns since they will have to rely more heavily on earnings growth than on multiple expansion; 2/ reduce the margin of safety in the event of a bear market, but are not sufficient to cause one. In a stable economic environment, low equity market volatility can last for years, as long as earnings dynamics are resilient – and investors may run the risk of being under-exposed.

Against this backdrop, we strive to design portfolios with limited exposure to the most expensive stock markets but that will stand to benefit should the current environment indeed persist. This involves for instance an underweighting of US markets to the benefit of European and emerging markets.

Having said that, investors concerned by their portfolios’ vulnerability to external shocks (which could be triggered, for instance, by geopolitical risk) or/and willing to lock in this year’s strong performance might take advantage of the currently low volatility levels to buy protections.